Search This Blog

Tuesday, January 7, 2014


As you may know, Traditional IRA contributions reduce your taxable income for the year in which they are made.   

For example: Say you make $100,000 and contribute $15,000 to your traditional 401(k) plan. Your taxable income is immediately reduced to $85,000. Furthermore, the money you invest grows tax-deferred until you withdraw it during retirement. And at that time, you will pay ordinary income tax on all traditional contributions and the gains.

Alternately, Roth contributions won’t reduce your current taxable income. But you pay no taxes on the Roth distributions during retirement. You pay the taxes up front, and the rules today state gains aren't subject to taxation either.

The other thing to keep in mind is that any traditional retirement accounts (non-ROTH) are also subject to Required Minimum Distributions[1] (RMD’s) which have to begin no later than April 1 following the year in you turn 70 ½. They must then be distributed each subsequent year thereafter. ROTH IRA's, however, are not subject to this.

Deciding whether to Roth

People who are in their peak earning years just prior to retirement generally stand to benefit most from traditional contributions. In those high-earning years, traditional contributions could help by moving you into a lower tax bracket which could have a significant impact on your tax bill. 

During early or lower earning years, there is typically less of a need to reduce down to a lower tax bracket, so it generally makes sense to make Roth contributions. Keep in mind that there are a lot of gray areas, as tax and income situations vary widely. And tax laws could change by the time you retire.  

There isn't a perfect plan for deciding on Roth, traditional, or blended contributions. You can, however, diversify to mitigate tax risks. Given we never know exactly which laws will change or exactly to the dollar how much you will make “blending” could be the answer. You can blend so that you’re making both Roth and traditional contributions. 

As you get into your 50’s and nearer to retirement than not, odds are that your income is closer to a peak and reducing your taxable income may be beneficial. But, ultimately, much of the decision hinges on whether you feel more comfortable paying taxes now or later and whether you’re willing to risk tax uncertainty during retirement years in exchange for a beneficial tax situation now.

Tax diversification is appropriate for nearly every retirement investor. The percentage of ROTH to Traditional will vary based on your personal situation and comfort level.  I am a big believer that everyone who is eligible to contribute to a ROTH in any way – should. It creates a non-taxable asset pool from which you can take a distribution to help pay the taxes on your taxable income. There is nothing worse than having to take money out of a taxable account to only then be forced to pay taxes on money used to pay taxes!

Things to consider when deciding ROTH vs Traditional:

1.       Will you be in a lower tax bracket during retirement?

2.       Do you need to reduce your current tax burden?

3.       What is your current ratio of taxable assets to non-taxable assets?

4.       Do you think income tax rates will go up in the future, remain the same or go down?

5.       How much money so you anticipate having to withdraw each year to offset your
       shortfall (after pension and social security)?

While no one can predict the future the general rule is: if you think you will be in a lower tax bracket during retirement then use a Traditional IRA.  That being said, I think it is wise to have a portion of money in a ROTH – at least enough to use to cover the taxes on your taxable income.

[1] These required minimum distributions are determined by dividing the prior year-end fair market value of the retirement account by the applicable distribution period or life expectancy; the calculation is based on the aggregate of all qualified plans; if you are still working, you may qualify for an exception.

No comments:

Post a Comment